Definition of subsidized loan
What is a subsidized loan?
A subsidized loan is an interest-free loan or below market interest rate. Also known as “low rate finance” or “concessional finance,” low rate loans have lenient terms, such as extended grace periods in which only interest or service charges are due, and leave of interest. They generally offer longer amortization schedules (in some cases up to 50 years) than conventional bank loans.
Low-interest loans are often granted by multinational development banks (such as the Asian Development Fund), subsidiaries of the world bank, or from federal governments (or government agencies) to developing countries that would be unable to borrow at market rates.
How does a subsidized loan work
Soft loans are often offered not only to support developing countries, but also to forge economic and political links with them. This often happens if the borrowing country has a resource or material of interest to the lender, who may want not only repayment of the loan, but also favorable access to that resource.
Key points to remember
- A “low rate financing” or “low rate loan” is a loan given with almost no interest or no interest with extended grace periods, offering more leniency than traditional loans.
- Many developing countries that need funds but cannot afford to borrow at market rates.
- In the case of public lenders, soft loans can be used to forge links between lending and borrowing countries.
China, in particular, has been active in extending funding to African countries over the past decade. For example, Ethiopia received $ 10.7 billion in loans from the Chinese government from 2010 to 2015, according to the China-Africa Research Initiative at Johns Hopkins University School of Advanced International Studies. This includes a full package of grants and soft loans totaling $ 23 million to support Ethiopian development and infrastructure, such as power lines, cellular networks, industrial parks, roads and a railroad connecting the cities of Djibouti. and Addis Ababa, the Ethiopian capital. The loans are all part of China’s plan to support Ethiopia and promote trade development between the African country and the Asian giant.
In another example, the Chinese government granted a soft loan of $ 2 billion to Angola in March 2004. The loan was given in exchange for its commitment to provide a continuous supply of crude oil to China.
A soft loan is financing on generous terms – a below-market interest rate, for example – that is often offered to developing countries.
Advantages and disadvantages of subsidized loans
While subsidized loans may at first glance seem like a win-win situation, they have drawbacks – as well as advantages – for lenders.
Pro: Business breaks
In addition to serving as a platform for the lender to establish broader diplomacy and policies with the borrower, soft loans provide favorable business opportunities. The aforementioned railway and industrial parks in Ethiopia are not only built with Chinese funds, but by Chinese companies. Many of the companies that move into the resorts are also Chinese, and they enjoy significant tax breaks on Ethiopian government revenues and imports.
Downside: shaky returns
The time it takes to repay a subsidized loan can mean that the lender is tied to the borrower for an extended number of years. While this could mean that the lender might not see a direct return on the funding they have offered for some time, it does create an opportunity to engage with the borrower for other purposes.
For example, in 2015, Japan offered a low rate loan to India to cover 80% of the cost of a $ 15 billion bullet train project at an interest rate of less than 1%, with the proviso that India would purchase 30% of the equipment. for the project of Japanese companies. By the time the countries signed a formal agreement, Japan’s commitment rose to 85% of the cost, in the form of soft loans, at an estimated project cost of $ 19 billion.
There is also the problem of the borrower having repayment problems despite the generous terms of the soft loan. Nations may be tempted to take on more debt than they can afford. Such a situation has occurred with Ethiopia.
Thanks to these Chinese loans, his debt to GDP ratio was 88%, and it was in danger of failing them. In September 2018, China had to agree to restructure part of the debt, reducing repayments and extending loan terms by 20 years. Nevertheless, China intended to implement eight other major initiatives with African countries by 2021.